Agricultural producers face substantial risks in producing an agricultural product, bringing it to market, and earning a profit. Individual farmers, for example, are especially susceptible to risk factors that can adversely affect yield, marketability, and market price. Risk factors include weather conditions such as drought, hail, wind, frost, and excess rain, plant disease, insects, market volatility, increased global capacity, and government regulations. To offset some of the risks associated with market volatility, many producers enter into marketing agreements with buyers of agricultural products.
Marketing agreements often set prices based on futures, and may include quantity requirements, price floors, and price ceilings. With a marketing agreement, the agricultural producer may achieve some level of comfort in his ability to market products at a reasonable price. The marketing agreement thereby reduces the agricultural producer's vulnerability to price risks that can cut into profits and even drive him out of business. In turn, the buyer achieves access to a predetermined quantity of product.
Many buyers hedge the implicit risks associated with the price obligations in the marketing agreement. In general, a buyer's “hedging” involves trading to protect the buyer against the risk of an unfavorable price change from the time the marketing agreement is made to the time that the agricultural products are actually purchased. Hedging may involve trading futures contracts and/or options on futures contracts. Options may be purchased from a derivatives hedging products (DHP) supplier or from another options writer.